Rational Mispricing with Unpredictable Demand Shocks

Movements in prices depend both on innovations to cashflows and changes in discount rates, which can be modelled as fluctuations in the cross-sectional distribution of wealth across an unchanging set of investment objectives. This paper explores the risk that arises when investors do not have perfect information about the wealth distribution, and, as a result, cannot forecast prices accurately. To take into account this risk, investors plan their consumption for all realisations of the wealth distribution according to their subjective beliefs. This makes markets highly incomplete, and derivative assets become non-redundant. Derivatives serve a dual purpose: they allow investors to adjust consumption for different realisations of the wealth distribution, and provide information required to implement optimal allocation decisions. Asset prices, and expected returns, depend on the sensitivity of stochastic discount factor and assets' payoffs to the wealth distribution. Prices of derivatives deviate from the expected cost of creating synthetic derivatives through dynamic trading, creating apparent mispricings between derivatives and primary assets. The imprecise information about the wealth distribution can induce an additional demand for dynamic trading, so that passive investment strategies are no longer optimal. Our results also have implications for arbitrage activity, informational efficiency of prices, and the role of financial innovation